Fighting for Tax-deferred "Rights"

Since Eisenhower occupied the Oval Office, owners of business and income property have been able to exchange "like kind" real property and benefit from deferred tax treatment on gains. The Internal Revenue Service rules are relatively straightforward about what qualifies as like-kind property. The classification is a function of the nature or character of the property, as opposed to its grade or quality.

Indeed, under Section 1031(a)(1) of the tax code, an office building generally can be exchanged for another office building, and a fleet of trucks can be swapped out for another fleet, without triggering an immediate tax hit when the newly acquired property is worth more than the old. This permissive approach means that virtually any variety of real estate can be exchanged, on a tax-free basis, for any other interest in real estate.

Other caveats apply, including that the newly acquired property has to be used in a trade or business, or for investment. But in general, the types of property rights and interests that constitute interests in real property — and may be considered like kind to real property for purposes of the tax code are, if nothing else, exceedingly broad.

Accordingly, it is well-settled that unimproved land can be exchanged tax-free for improved land. That is, the properties, in this case, may differ in terms of their grade or quality but, nonetheless, are of the same kind or class. In addition, a fee or ownership interest in realty can be exchanged, on a tax-free basis, for a leasehold interest with respect to real estate that has a remaining term, taking into account renewal options of at least 30 years.

What is less apparent, however, is whether a property right represents an interest in real estate — and provides owners with a Section 1031 tax deferral.

Local Law Controls
The IRS acknowledges that local law generally determines whether assets are considered real property or personal property. For example, in an October letter issued by the service, (LTR 200805012, October 30, 2007) it provides an example of a C corporation that owned a fee interest — one that is free and clear of all ownership conditions — in two properties, each located in the same city. For clarity's sake, let's call the C corporation ZedCo, the two properties Alpha Complex and Beta Complex, and the city Plainsboro.

In the scenario, ZedCo intends to transfer its fee interest in Alpha to a qualified intermediary — an independent company that facilitates Section 1031 exchanges — who will then sell Alpha to a third party purchaser. The intermediary, in turn, uses the sales proceeds to purchase Alpha developments rights. Plainsboro law defines development rights as the "rights granted to a parcel of land under a zoning ordinance respecting permissible use, area, bulk, or height of improvements executed thereon." Finally, the intermediary transfers the development rights to ZedCo.

Owning the development rights allows ZedCo to develop Beta Property with "greater floor space" than would otherwise be allowed while retaining tax-deferred status. Why? The IRS ruling notes that local law tax statutes define an "interest in real property" to include development rights. Moreover, the ruling notes that a transfer of development rights is subject to local gains tax as a "transfer of real property."

However, in finding that the transaction fits within the non-recognition provisions of Section 1031(a)(1) of the tax code, meaning that the gain will not be immediately recognized for tax purposes, the October IRS letter makes the following observations:
• ZedCo is proposing to acquire development rights and transfer those rights to Beta, which the corporation already owns. This transfer, however, is not an impediment to ZedCo's claim that the Section 1031(a)(1) tax deferment applies to the exchange. Indeed, the IRS, in citing a 1968 revenue ruling (Rev. Rul. 68-394, 1968-2 C.B. 338) said that it was "immaterial" that development rights will be used merely to enhance the real property that is already owned by the company, which in this case refers to Beta Complex. Furthermore, the ruling indicates that for purposes of Section 1031(a)(1), it is not material that the property acquired, as the replacement property, happens to be on property already owned by the ZedCo.
• Local law treats development rights as an "interest in real property."
• Development rights are not discretionary, which means that they exist permanently, and therefore are analogous to perpetual rights. This finding brought the case within the safe harbor established in its 1955 revenue rule on water rights (Rev. Rul. 55-749, 1955-2 C.B. 295).
In that ruling, the IRS found that Sec. 1031(a)(1) applied to the exchange of raw land for perpetual water rights which were, under local law, considered real property rights.

So, although a casual observer may not consider development rights to be real estate, the rights involved in this case easily attained that designation. In light of the fact that the development rights at issue here were perpetual and, under local law, represented an interest in real property, the rights were regarded "as of like kind" to the fee interest in Alpha, for which they were exchanged. Perhaps more importantly, ZedCo was able to consummate the exchange on a wholly tax-free basis.

Contributor Robert Willens, founder and principle of Robert Willens LLC, writes a regular tax column for CFO.com.